"Whether appropriate or not, the term 'value investing' is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, a low dividend yield - are in no way inconsistent with a 'value' purchase."
- Warren Buffett (Trades, Portfolio)'s 1992 Letter to Shareholders
While reviewing my investment journal a few days ago, I noticed something interesting: MasterCard showed up in my journal multiple times since 2011 and each time my note was something like "it's not cheap enough, pass." I wrote almost the same note about Priceline for the past several years. Until recently I had been foolishly proud about my self-perceived discipline - they have never gotten cheap enough for me to buy it.
This all changed in my Omaha trip this year. Through my conversation with a few renowned value investors such as Chuck Akre (Trades, Portfolio) and Gaynor, I learned something enormously important yet often lost in plain sight: the fear of paying a high multiple for compounding machines often leads regrettable mistakes of omission.
If we think about it, this is such a profound statement. I've only been a value investor since 2011 but all these years, I've suffered from the fear of paying a high multiple for extraordinary businesses.Looking back, MasterCard and Priceline rarely looked cheap from a multiple valuation perspective.
When I first looked at MasterCard back in 2011, it was almost 50% cheaper than it is today and the P/E ratio was about 25. How could I blame myself for not investing in a stock that had a P/E of 25? Such is the power of ignorance combined with sloth.
Chuck Akre (Trades, Portfolio) talked about MasterCard's superior business model in his presentation at the Value Investor Conference. During his presentation he gave the following example: Say a company's stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner's capital.